Euro Dividends

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GlobalEquity-Linked: Dividends 01 September 2010
Market Stephen Cohen +44 20 7103 6073 Stephen.Cohen@nomura.com

Neil Sheppard +81 3 6703 2254 Neil.Sheppard@nomura.com
Commentary
Hariharan Sairaman +44 207 103 8586 Hariharan.Sairaman@nomura.com
Vincent Li +852 2252 2494 Vincent.Li@nomura.com
Eamonn Long +44 207 103 5762 Eamonn.Long@nomura.com
Dividends: Spot the misalignment

Trade Idea:
 Buy SX5E futures versus selling a strip of SX5E dividends; equal notional both sides
 Buy SX5E futures versus selling a strip of SX5E dividends with 1yr-5yr €-swap payers; equal yield
notional both sides
We return to a theme last prevalent in April this year: relatively over-priced dividends. As in our note at the end of
April (“Dividends not so discounted”, 30 April 2010), we believe now is the time to sell the SX5E dividend strip
versus SX5E futures, following the significant reduction (~ 20%) in longer-dated bond yields. The rationale is that if
the dividend market is fairly priced there would appear to be significant scope for equities to rally in the search for
yield or if the equity market is fairly priced there would appear to be significant scope for dividends to sell off. We
examine the dividend curve from the perspective of an investor searching for yield, the dividend discount model,
the bottom-up of analyst estimates, the historical dividend payments on the SX5E and the supply demand
perspective.
 Income Pricing: It seems that the dividend market is happy to buy (i.e. not the market expectation, but
where it is happy to buy) dividends at around 100 for the next 10 years. Given that the curve is upward
sloping at the back-end, it is reasonable to assume that if there were a market for dividends beyond 2019,
these would also trade above 100. Hence, the market is assuming that equities will yield at least 3.6%
forever. However, bunds out to thirty years yield hardly yield 2.7%. Since the dividends are priced at
such a high yield for the next 10 years it is arguable that equities are 30% too cheap with respect to dividends,
especially longer-dated dividends.
 Dividend discount model: The key point is that the present value of the dividend curve should be lower than
the spot to account for lower liquidity of dividends. The graph on the lower left shows that a combination of
lower bond yields and outperforming dividends has driven the present-value of dividends well above the
current spot on the SX5E. This ratio should be normally less than 1 – as it currently for the NKY and UKX.
The chart on the lower right shows the 5 year implied dividend yield versus the 1year 5 year rate on the Euro
(please see the section on rates and yields for justification of the comparison).
The ratio of the present value of the present value of the The rolling 5 year implied dividend yield on the Euro
SX5E dividend curve (Implied spot) to the SX5E spot. This STOXX 50 versus the 1year 5year forward rate on the Euro.
ratio should be theoretically less than 1. Currently, SX5E A significant discrepancy has arisen over the past month.
dividends look extremely overvalued, relative to the SX5E. Please see the section on rates and yields.
1.2
6.0% Large recent divergence
1.1 SELL 5.5% in asset classes
1 5.0%
4.5%
0.9
4.0%
0.8
3.5%
0.7 3.0%
Yield
2.5%
0.6 BUY Fwd Rate
Ratio 2.0%
0.5
2005 2006 2007 2008 2009 2010
Apr 06 Apr 07 Apr 08 Apr 09 Apr 10
Source: Bloomberg, Global Equity-Linked Source: Bloomberg, Global Equity-Linked
1
This sales note is produced by Nomura Equities and is not Nomura Research. For Institutional Clients only; US Institutional
Clients should contact Samir Patel (+1 212 667 1253) or their NSI sales representative.
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 Bottom up: Half of the forecast dividends for 2011 and 2012 come from stocks which would yield above
6.5% at current prices. If the dividends of these stocks really are safe; given the low yields on bonds,
these stocks should see aggressive buyers. A related point is that if these stocks continue to pay out a
large percentage of their market capitalisation every year they will eventually be replaced in the index by
outperforming low yielders with a similar profit profile. For example, Aegon (used to pay around 4%) will
exit the SX5E index this year to be replaced most probably by BMW (yield less than 2%).
Forecast dividends on the SX5E by implied yields for

the stock. More than half the dividends are due from The present value of the Euro STOXX 50 dividend curve
stocks that would yield over 6.5%. In a low rates (Implied spot) versus the 1 / Market cap weighted average
environment, either the stock should rally, or the of the CDS of the index constituents. It looks as though the
market does not believe such dividends are dividends have disconnected from credit.
sustainable.
45 3000
1.8
40 2800
35 2600 1.6
2400
30 1.4
2200
25 1.2
2000
20
2012 1800 1
15
2011 1600
10 Implied 0.8
1400 Spot
5 0.6
1200 1/CDS
0 1000 0.4
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% Jun 08 Dec 08 Jun 09 Dec 09 Jun 10
 History: In 2002 and 2003, when the SX5E was last around these levels, the index paid out around 80
points of dividends. Interest rates were at or above the current level at the time.
 Supply: There is still a large overhang of dividends, not least from the $37bn notional long-dated put
trades (15 years+) involving a well known re-insurance firm placed between 2004 and 2008. While these
puts may have been restructured in the interim, a back of the envelope calculation shows that this SX5E
dividend risk is potentially of a similar size to the total open interest on all SX5E dividend futures: notional
~ €4 billion.
Rates and Yields: Implied dividend yields should be eventually less than forward
interest rates
Dividends and 1 year interest rates both represent expectations of returns on assets in a given year and as such,
the two should exhibit a positive correlation. A related point is that interest rates are typically raised to „cool‟
nominal growth and lowered to stimulate nominal growth. With this line of reasoning, expectations of high interest
rates in a given year would be related to expectations of high nominal growth, high nominal profit growth and thus
to higher dividend payments. Conversely, expectations of low interest rates in a given year would be related to low
nominal growth and ultimately lower dividends paid.
An alternative perspective is offered by the dividend discount model. Let Dn represent the market price for
dividends paid in year n. Let Fn be the discount factor for year n and rn be the forward interest rate between year n-
1 and year n so that, for n>0,
Fn ( 1 + rn ) = Fn-1.
Under the dividend discount model,
∞n=1 Dn Fn = S
where S is the spot price of the index. Following on from the previous paragraph, let‟s consider the trial solution
Dn = rn S.
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∞
The trial solution is consistent with the dividend discount model because rn Fn = Fn-1 - Fn and F0 = 1, so that  n=1 rn
Fn= 1 as the left hand side is a telescopic sum. Thus, the solution Dn = rn S matches with intuition, the dividend
discount model and, as per the graph on page 1, smoothed market data (eg running weekly averages). We remark
that it is possible to turn the „discrete time‟ argument above into a „continuous-time‟ argument, but our purpose here
is to stick, inasmuch as it is possible, to what is can be traded.
It is possible to object there are infinitely many acceptable forms of the dividend curve. This point is correct,
however, it is not a specific objection to the form of dividend curve chosen. One could also point out that there must
be some connexion between the dividends of the nearest year or two with history (dividend „stickiness‟) whereas
the spot price is usually taken to be an expectation of the future only. This is true, but, notwithstanding the liquidity
differences, the gap-risk differences, the supply demand imbalance in the dividend market, we remark that where
dividend yields are so much higher on the shorter-end of the dividend curve than forward interest rates, an
implication of our trial solution Dn = rn S is that, at some point on the curve, implied dividend yields must
be lower than the respective 1year forward interest rates for the dividend discount model to be satisfied;
otherwise dividends are too expensive relative to the equity and rate markets. Furthermore, given the
connexion between shorter-dated dividends and past dividends, any correction to this misalignment would
seem to be due to occur on the mid to longer-end.
Implied dividend yield on the SX5E versus the 1-year Implied dividend yield on the SX5E versus the 1-year
forward interest rates on the Euro: 01 Sep 10 forward interest rates on the Euro: end July
This gap has to Floating on air? 4.5%
be reversed 4.5%
later, according 4.0%
4.0%
to the dividend 3.5%
discount model 3.5%
3.0% 3.0%
2.5% 2.5%
2.0% 2.0%
Dividend Yield Dividend Yield
1.5% 1.5%
Forward Rate Forward Rate
1.0% 1.0%
0.5%
0.5%
0.0%
0.0%
2010 2012 2014 2016 2018
2010 2012 2014 2016 2018
Conclusion
 The dividend curve could be viewed as relatively optimistic for two reasons:
(i) the market is happy to have a risk-adjusted dividend yield on the SX5E 20%+ higher than bond yields
indefinitely suggesting either equities are too cheap or bonds too expensive;
(ii) the dividend curve is upward sloping on the back-end, implying not only the sustainability of high yields
but also that these yields could grow. However, equities seem to be pricing in macro-economic
concerns about the future and bonds are arguably priced for disinflation and possibly deflation.
 Conversely, equity and bond markets are arguably too pessimistic, at least, in respect to dividends.
While this is possible, an interesting implication of the preceding line of thought might be that the combined
money at risk in the equity markets and bond markets is not as informed as the much smaller money at risk
in the dividend market.
To take advantage of this dislocation we recommend selling dividends and buying the underlying cash equity
market.
 Sell SX5E dividends from 2012 onwards versus the spot

 Sell SX5E dividends from 2012 onwards versus the spot; enter into 1yr5yr €-swap payers
3
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Appendix - More on the dividend discount model

The spot price should be at least the present value of the dividends
The approach is to assume that the price of any security should be between the risk-adjusted present value of all
future dividends and the risk-adjusted present value of all future earnings; i.e. between the price that a passive
investor would pay to own all future dividends and the price that an investor would pay to control and use all future
earnings of the underlying.
An objection to this approach would be that it accounts neither for the intervention of speculators nor for the
intervention of investors behaving irrationally. On the other hand, the disproportionate presence of either such
interventions could be viewed as an opportunity.
Not necessary to risk adjust dividend levels, the market already does so
The phrase risk-adjusted present value is key here. Conventionally, one would be expected to know that market‟s
expectation of the future dividends as well as the discount rate that the market would apply to assets with that level
of risk. Fortunately, the existence of the dividend swap/futures market means that it isn‟t necessary to know either
as the levels are already risk-adjusted (though not adjusted to the risk-free present value) by the market in which
they are trading. As the dividends market is smaller than both the interest rate market and the market in equity
indices, it is possible to argue that any misalignment is in the dividend market.
An objection to this is that risk adjustment might be greater in the dividend market than in other markets owing the
lower market size and potentially lower liquidity, and that we need to adjust for this. A response to this is that this
still means the price of a security should be higher than the present value of the dividends, as per the dividend
discount model.
Calculating the present value of dividends from the dividend futures market
The approach was to take the maturities presently tradeable, and extend the dividend curve out to 50 years by
assuming that the curve is flat after the last traded maturity. Normally, for the dividend discount model, it is
expected that the dividends would be known out to infinity. However, one might imagine that the expected
economically active lifespan of the reader would not much exceed 50 years, and that therefore 50 years may be
thought of as infinity for these purposes. As discussed already, the present value would be found by discounting
the dividend curve by the risk-free interest rate curve.
2015 to 2019 Steepener on the SX5E: the market doesn’t The SX5E dividend curve. The steepness of the back-end
seem to tolerate flat implied growth for very long – in of the curve is consistent with indefinite growth of implied
addition, these kind of trades are not trades to maturity. This dividends. However, the traded dividends are supposed to
seems to suggest that there is support for assuming that, be risk-adjusted. Such a steep dividend curve in the
beyond currently traded maturities on the dividend curve, flat presence of exceptionally low interest rates makes equities
or negative implied growth would not be tolerated. (also risk adjusted) look very cheap.
10 115
9
110
8
105
7
6 100
5 95
4
90
SX5E implied Dividend
3
85
2
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Dec 09 Jan 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10
4
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On balance, assuming a flat dividend curve from 2019 onwards seems conservative
To see how to extend the curve, note that for example, on the 19 Aug 2010, the last traded maturity was 2019 and
it traded at 104.6. To extend the curve out to 2059, assume that the dividends between 2019 and 2059 would trade
at 104.6. It turns out that this assumption is quite important because over the last year or so, between 60% and
75% of the present value of the dividend curve would come from the curve between 2019 and 2059. It remains to
justify as a conservative assumption taking the dividend curve as flat after 2019. On the one hand, it is possible to
argue that dividends have grown historically and therefore should continue to grow in the long run according to
inflation and real growth. It is possible to counter this by pointing out that it might be difficult to imagine natural
buyers for a bullet dividend payment in 30 years – except perhaps for those engaged in matching long-term
liabilities with assets. The latter is a quite an objection, however, given the current predilection for buying of
steepeners on the dividend curve especially on the back-end, it seems difficult to conceive the dividend market
being ready to accept a flat let alone downward sloping dividend curve. On balance, it seems that the assumption
of a flat dividend curve from 2019 is a conservative one.
Rebalancing effect of index included in dividend swap, not in index
A potential difficulty in this kind of analysis is the fact that it is reasonably certain that the constituents of an index
will change over time. The dividend future provides for the rebalancing via the contract specifications – the future is
a future on the cumulative dividends of the index in a given year where the dividends are added day by day
according to the companies in the index on the day. However, the spot price of the index does not incorporate this
effect – the spot price of the index is the aggregate price of the current constituents. As against that however, we
note that the forward on the SX5E is trading at a lower level than the spot (as a function of the implied dividend
yield being greater than the interest rates) and so the argument that the dividend curve is too high with respect to
the spot would remain valid.
5
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IDEAS Hub

GlobalEquity-Linked: Dividends 01 September 2010

Market Stephen Cohen +44 20 7103 6073 Stephen.Cohen@nomura.com

Dividends: Spot the misalignment

Source: Bloomberg, Global Equity-Linked Source: Bloomberg, Global Equity-Linked

GlobalEquity-Linked: Dividends 01 September 2010

Forecast dividends on the SX5E by implied yields for

Source: Bloomberg, Global Equity-Linked Source: Bloomberg, Global Equity-Linked

GlobalEquity-Linked: Dividends 01 September 2010

Source: Bloomberg, Global Equity-Linked Source: Bloomberg, Global Equity-Linked

 Sell SX5E dividends from 2012 onwards versus the spot

GlobalEquity-Linked: Dividends 01 September 2010

Appendix - More on the dividend discount model

Source: Bloomberg, Global Equity-Linked Source: Bloomberg, Global Equity-Linked

GlobalEquity-Linked: Dividends 01 September 2010

Rebalancing effect of index included in dividend swap, not in index

GlobalEquity-Linked: Dividends 01 September 2010

GlobalEquity-Linked: Dividends 01 September 2010

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